Investors fear inflation but run to it

Recent capital flows highlight a paradox: investors are afraid of inflation, but seem to have increased their allocation to just the assets that would do worst out of it.

Investors in corporate debt polled by Bank of America on June 23 listed inflation as their biggest worry, followed by bubbles in credit, and rising yields.

But they worry less about “normal” inflation measures such as consumer price inflation or commodity prices, which are seen as transitory, and more about food price inflation.

Year on year, global food prices have jumped by 40% and this “risks reversing poverty trends and ushering in higher policy uncertainty,” according to the analysis of the poll results by BofA.

The survey was carried out among 66 institutional investors such as banks, insurance firms, pensions firms, asset management firms and hedge funds that are the bank’s clients.

Looking at asset allocation, bond funds have seen increased capital flows, and so have stock market sectors known as “bond proxies”, such as utilities and real estate, according to data for the past four weeks published in Deutsche Bank’s latest investor positioning report.

This was supported by data from Bank of America, which shows that corporate bond funds have seen strong inflows in the past week.

For high grade corporate bond funds, last week’s inflow was the largest since mid-February, while high yield (junk-rated) bond funds saw their fifth weekly inflow.

Of the latter, global and euro-focused funds attracted new money, whereas US-focused high yield bond funds saw outflows.

This could have something to do with the perceived divergence between the two major central banks, the European Central Bank and the Federal Reserve.

Almost hawkish comments are beginning to be heard from the Fed, while the ECB is still in a very dovish mood.

But it could equally mean that central banks have lost their grip on the markets, with investors making their own minds up about what is to come.

Such a moment happened during the well-known “taper tantrum” of 2013, when investors sold off bonds heavily after the Fed said it would start tapering its asset purchases.

Another such instance happened more than six years ago, when the Swiss central bank scrapped the Swiss franc’s peg to the euro after a period of sharp appreciation of the Swiss currency.

At the time, investors’ faith in central bankers’ ability to guide the markets was badly shaken but, because the Fed and the ECB quickly re-established (or held) their course, these episodes ended up as just minor wobbles for markets.

Today’s environment is even more dovish than at the time, but, with central banks having been in easy money mode for more than a decade, the danger is much higher.

With financial assets and residential real estate prices spiking in the double-digits, any wrong move by a major central bank could spell disaster in the markets.